Friday, February 10, 2006

Google: “Thesis Schmesis”

Far and away the most interesting—and meaningful—conference call I’ve listened to the last couple of weeks was the Blue Nile on Tuesday night.

Blue Nile is what investors like to call “a nice little company”—with good sales growth, healthy margins, actual earnings, and real free cash flow.

Blue Nile also happens to be an internet retailer (of jewelry), and it learned about real free cash flow the hard way, having started up during the internet bubble and survived the internet crash thanks to the extreme diligence and sharp focus of its founder, Mark Vadon.

Unlike, say,, whose CEO went out and bought $7 million worth of diamonds and cobbled together a clunky “Design Your Own Jewelry” site to attempt to sell the stuff, Blue Nile operates as a virtual jewelry store with a terrific, user-friendly site and a well-developed supply chain.

Gross margins are half the brick-and-mortar model—but because Blue Nile carries almost no finished inventory and gets paid via credit card before whatever it sells (usually an engagement ring) is assembled and shipped, it generates good margins and real free cash flow that piles up on the balance sheet and goes into share buybacks when the stock gets beat up, as it occasionally does when the company misses quarters, which it occasionally does.

As it did this week.

Being an Internet pioneer that survived the bust, Blue Nile has also witnessed the rise of the Google/Overture keyword advertising model, whereby advertisers buy “keywords” and then pay Google or Overture (now Yahoo!) every time a user “clicks-through” the ad that pops up during a search of those keywords.

And ever since Google came public, Blue Nile has been answering questions about click fraud, cost-per-click and Microsoft’s intentions in the space, always reaffirming the value of keyword advertising to Blue Nile’s business model.

Just last November, Vadon told analysts the following:

And what we really have to do is not go out and run television commercials like an, but what we need to do is stay focused on delivering a great experience and let the market mature and let people grow comfortable with the Internet. If we do that, I think you’ll see us continue to grow at the rates we’re growing now for at least five more years.

But that was then, and this is now. Blue Nile missed its fourth quarter revenues and earnings by a wide mark, in large part owing to higher search-related marketing expenses. Specifically, Vadon said the following:

During December, we saw extremely aggressive increases in the cost of online advertising. Our cost per click on Google, for example, rose by over 50% from a year earlier. While the cost of online marketing grew significantly in Q4, we remain disciplined in our spending, in order to maintain profitability on new customers rather than to chase unprofitable growth, as some of our competitors have done.

If this sounds familiar, it should be. In “The Most Interesting Press Release You Didn’t Read” I highlighted comments from FTD Group in late December, which said essentially the same thing.

When asked for specifics, Vadon discussed “irrational behavior” in Google search pricing:

To give you perspective, in our top five keywords, our cost per click was up over 80% compared to a year ago. To us, it looks like, frankly, some irrational behavior in the marketplace. I think, if you follow our business, you know that we monetize Internet traffic for jewelry better than anybody in the world, and if we are getting nervous about the pricing of search, it means there's some people out there who are deficit spending and perhaps are back to the mentality of 1999….

As far as who is out there bidding, it's slightly different in Q4 as opposed to Q1. I think in Q4 -- you asked about Amazon. We haven't seen them at all in the online search market. We saw a couple larger players; I think Zales was pretty aggressive, Macy's was pretty aggressive. And then we see just a tremendous number of small players, and these are very small companies. And they don't play for very long. They will come into search for a week or a couple weeks. And I think there's just a lot of -- and then I think they burn through their budget fairly quickly and fall off the screen. But we just saw a lot of those types of players coming out.

The problem is not limited to the cost of keywords themselves: it extends to the diluted quality of the internet users clicking through to the Blue Nile web site, following Google’s move last summer to place more paid ads per search:

So an important matter is how well you can convert. Over time from search, we see slight declines, and it's not tremendous but slight declines in the conversion rate. I think, to some extent, that has to do with the search engines placing more ads. So, when you went to a search term a year ago versus going to it today, you are going to see more paid search placements today than you did a year ago.

Furthermore, as more companies advertise on search engines, the value of the incremental customer is dropping:And as there's more people there competing for the same traffic, if one consumer is shopping -- so if you're shopping for a plasma TV, you are probably going to go to many merchants, or at least a handful of merchants, before you make your purchase. And so you will be clicking on multiple ones of those, but only buying one plasma screen. And the more paid placements there are, probably the more click-throughs you're going to have.So what that results in for merchants is downward pressure on the value of those customers

Having always thought highly of the Blue Nile CEO and his company’s business model, I’d say something has changed, quickly and significantly—in ways not discussed on Google’s own quarterly earnings call last week.

This is most apparent in the fact that Blue Nile, which has almost exclusively marketed online, is, like FTD Group, considering a shift away from online search:

Given these results, we will be looking to broaden our marketing efforts beyond search in the future. As we seek alternative marketing vehicles to complement our efforts in paid search, I would expect growth to be relatively conservative as we ramp our efforts toward broadening our marketing outreach. This is the right long-term solution for our business. As I've stated before, throughout all of our marketing efforts, our focus is on the maximization of gross profit contribution, in keeping with our overarching objective of free cash flow generation….

So what that results in for merchants is downward pressure on the value of those customers. So just as bidding is going up, you're seeing downward pressure in conversion. Again, this points to our desire in the channel to be less aggressive with our bidding. And if that means giving up some volume to other people who perhaps are not measuring that and doing that ROI calculation, as well, we will do that until it rationalizes somewhat.

I’ll be the first to say I didn’t expect to hear comments like these for another year or two. Just two weeks ago ("Google: 'Our Thesis is Still Intact'") I reported that various sources within the corporate Google-using community, with one exception, saw no FTD Group-style slow-down in their marketing spend on paid search.

But with Blue Nile easing off the Google search pedal, it looks like the internet search market is indeed rationalizing—not because of Microsoft and not because of click fraud, but because of good old-fashioned free markets.

And it’s happening now, in Internet Time.

Jeff Matthews
I Am Not Making This Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.


Its_strange said...

Google should team up with that company ( i forget the name ) that insures against identity theft . And if your identity is hacked they return everything back to normal . Thats what Google should do ...

NFI ...Nice work Phil Saunders !

Chug-A-Bug said...

Only slightly off topic...

Blue Nile is one of the classiest operations I've ever dealt with. It is the anti-Dell. Reading this explanation for their miss rekindles my interest in investing with them (in the hopes of recouping the $$$ well spent on their website).

hundredyearstorm said...

Jeff, great piece. I appreciate the fact that you have admitted to being long GOOG and yet are searching high and far for any sign of a "chink in the armor". One of the problems the CEO identifies is that of fly by night irrational competitors that in an auction environment can screw up the economics for the longer term rational players, like Blue Nile. Because the barrier to entry of bidding on keywords is relatively low, its not unexpected that large numbers of small players will come into the marketplace, bid up keywords, realize the economics don't work, and go under, only to be replaced by the next upstart. In the end, it most hurts those companies trying to build a sustainable business. Maybe GOOG can look into stricter qualifying standards for bidders, but it is difficult for companies to turn away customers that are in fact responsible for driving the "bubble" in keywords.

BDG123 said...

I usually live by the belief that simple reasoning wins out in the end. People make things too complicated when investing. If it's too complicated, it likely isn't something I want to invest in. There is much to like about Google but we saw during slow downs that internet companies are the first to crater.

And you know, Google doesn't really do anything very well that they are paid for. They just do it better than anyone else. So, is this a company to own for the ages? Quite possibly. But only if their brand continues to develop. That means they need to lead the way in paid search innovation amongst other endeavors they may undertake.

Then again, look at history and show me cases where brands became timeless when they did something better than anyone else but still weren't very good at it. Where customers spent a boatload of money and ultimately determined the ROI didn't exceed the hurdle rate or even didn't exist at all. I believe there is alot of experimentation in web advertising. Let's throw something against the wall and see if it sticks. And most haven't figured out how to turn that ad spending into revenue. Savvy advertisers and marketeers will eventually optimize their dollar spend around a quantified result. And when their brand becomes so pervasive in the online medium, they will likely have to advertise less and less. ie, eBay and Amazon.

This is still a very immature industry likely rife with trials and tribulations.

Chris Fischer said...


I have to ask, why did you think Google was going to produce these torrid growth rates for the next 2 years? Internet usage is not growing at rates it used to- so these torrid growth google has achieved had to be a good mix of

1) The internet market itself growing (anyone have any idea what this is? maybe 20% y/o/y? probably less?)
2) Google eating Yahoo and MSN's lunch
3) Google increasing pricing/monetization of search

Google has done an impressive job on #'s 2 and 3 over the last 2 years, but I can't believe it has much more it can squeeze out, although who knows. (A decent discussion of the increased monitization was provided, pre-earnings, by a yahoo search employee at . Take it with a grain of salt because it's a competitor, but its a good, quick read)

#1 is exactly what Blue Nile's CEO is talking about. I shop online for as much as I can. I often use Google(and Froogle) to locate the best prices. However, I'm not really planning on spending any more money online this year than I did last year. I have to think a lot of people are in the same boat as me. Sure, there are more people buying stuff online every year, but not the 50%+/year more than happened from 1996-2000...

So at some point, once the pricing reaches an equilibrium (which it looks like it might have) where does google expect to grow at 50+% from for the next 5 years?

Another thing I wonder, since I personally think we're headed for some rough economic waters ahead, is what happens to search pricing, even in a moderate recession? What are your thoughts?

Its_strange said...

If Gooogle starts offering Net access along with a computer and identity theft protection i'm with them for life ...See ya MSFT and Dell and Yahoo and the whole bunch....

"a la carte" TV means Google TV

Haz said...

I think the phenomenon that what we are now seeing is that the Big Retailers (or their ad agenencies) are becoming more aggressive in their online advertsing campaigns. They don't think solely in terms of ROI on an ad spend, but more along the lines of budgets and revenues, so they are willing to compete hard for that top spot on Google because it drives the traffic. It is still only a minor portion of their total ad spend a year.

Tarmac said...

It is not terribly uncommon to hear companies complain about search pricing. I remember a meeting with IACI I had in April of 04 where they said search pricing had gotten irrational. It is all very vertical dependent I my feeling is that it goes through cycles.

hundredyearstorm said...

Having just read the transcript, Jeff I can't believe you didn't take the opportunity to point out what Vardon said about MSN Shopping. Amazing that a broad shopping site would bid on keyword search, where the cost per click is such that you need a much higher conversion rate then one gets on a shopping site. Seemed like a free chance to take a shot at Mr. Softee.

Aaron Koral said...

Hi Jeff - there's an interesting article today in this week's Barron’s regarding GOOG. Seems as if the author is bearish on GOOG's maintaining its lofty valuation for long due to factors such as slowing revenue growth and increasing operating costs.

There was, however, one "blurb" in the article that caught my eye. GOOG has recently entered into a partnership with Liberty Media (ticker symbol: L) to provide broadband access over power lines (think utilities).

The technology provider is through Current Communications Group LLC. Both GOOG and L back the company, along with Goldman Sachs, (GS), Cinergy (CIN), and the Hearst Corporation.

After reviewing the web site, trial offerings of broadband service in states like Texas and Ohio. If the trials are successful, one can only imagine what an increase in revenues will mean for other utilities' profits, where little cost of capital is needed to deploy the service.

I wonder what GOOG would get out of the partnership if the technology is adopted by other utilities and becomes successful? I could be wrong, though....

Stock Quant said...


nice post, as usual :). Why not simply take a look at what GOOG advertising costs on their own platform? You could just go create an AdWords account (5 Euros here in Germany) and use the keyword tool.

I used my account to look for the CPCs that Google suggests .. quite hefty.

Check it out:

Traffic Estimator
Keywords Avg. CPC
books €1.36
diamonds €2.42
flowers €5.68
jewelry €1.78

If you'd like me to check some more keyowrds, drop me a mail via

bpl1000 said...

I recently shopped for a piece of jewelry- in the end I did not buy from Blue Nile, but to reflect chug-a-bug's sentiments, they have an incredibly solid reputation. I didn't need any kind of advertising to tell me that.

Phil said...

We've been following Google down since earnings and it's nice to see additional research being done on rational reasons behind the decline.

It seems that outside the hype machine, there may be some real problems coming to the surface here.

Check out our site for a deep discussion of earnings expectations as well:

Tim said...

I'd be hesitant to draw sweeping conclusions about the search marketplace from a sample of only these two. Both Flowers and Jewelry are categories that rely heavily on a few key phrases "buy roses"; "engagement ring", and whose businesses have low barriers to entry.

While FTD and BlueNile are to be commended for executing on the arbitrage opportunity that existed for these terms (i.e. Google's CPC was lower than true market value), it's fairly predictable that it would be among the first to dry up.

The right question to be asking next is whether advertisers that have a very deep product index and/or high barriers to entry are seeing the same issues. If not, there may be plenty of growth yet in the "long-tail" of search.

rub1232000 said...

looks like a positive for the newspaper stocks

fCh said...

Chug-A-Bug, Blue Nile has had some insider selling lately. Have a look and say again, why do you think this is a keeper?

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